Banks Best Basel as Global Regulators Dilute or Postpone New Capital Rules

By Yalman Onaran -
Dec 21, 2010

More than 500 representatives from
27 nations, including top regulators and central bankers, met
dozens of times this year to hammer out 440 pages of new rules
to govern the world’s banks.

What’s not in the documents published by the Basel
Committee on Banking Supervision, and the escape hatches that
are, may have more impact on how financial institutions will
operate following a global credit crisis that led to $1.8
trillion in bank losses and writedowns.

The committee’s most significant achievement, members say,
an agreement to increase the amount of capital banks need to
hold, won’t go into full effect for eight years. Other measures
that regulators had hoped would prevent future crises --
liquidity standards, a capital surcharge on the biggest lenders
and a global resolution mechanism for failing firms -- were
postponed, allowing banks to escape the toughest rules that
would force them to change the way they do business.

“There will be changes, but not fundamental changes to the
banking model,” said Sheila Bair, who as chairman of the U.S.
Federal Deposit Insurance Corp. sits on the Basel committee’s
top decision-making body. “Hopefully there’ll be some pressure
for banks to get smaller and simpler.”

Bair, 56, is one of five U.S. representatives on the board.
She has assailed bankers for exaggerating the impact of planned
regulations in an effort to scare the public and politicians. In
an interview in June, she questioned “whether regulators can
place any reliance on industry analysis of the impact of
proposals to strengthen capital rules.”

Bank Lobbying

Banks carried out a yearlong campaign to blunt
international regulations, arguing that efforts to rein them in
would curb lending and impede economic recovery. The lobbying
effort was led by the Institute of International Finance, which
represents more than 400 financial firms around the world and is
chaired by Josef Ackermann, Deutsche Bank AG’s chief executive
officer. Ackermann and other IIF members wrote hundreds of
letters to the Basel committee, met with regulators and
addressed forums from Seoul to Washington.

In June, the group published a report estimating that the
proposed capital rules would result in 9.7 million fewer jobs
being created and erase 3.1 percent of global economic growth --
estimates the Basel committee later challenged.

“There is no question that increased costs to banks of
core capital and funding will have to be largely passed along,
which inevitably will take a macroeconomic toll,” Ackermann,
62, said when he presented the report.

Battle Lines

Banks also reached out to their home regulators, arguing
that some rules would disadvantage them more than other nations’
lenders. That helped draw the battle lines inside the Basel
committee, according to an account pieced together from
interviews with half a dozen members who asked not to be
identified because the deliberations aren’t public. Germany,
France and Japan led the push for softening rules proposed last
December and stretching out their implementation. The U.S., U.K.
and Switzerland opposed changes or delays.

The committee agreed in July to narrow the definition of
what counts as bank capital, focusing on common equity, which
includes money received for selling shares and retained
earnings. During the crisis, other forms of capital permitted
under current rules, such as future benefits from servicing
mortgages and tax deferrals, failed to provide a buffer against
losses. Those are mostly disallowed under Basel III, as the
rules published last week are known.

Canada Switch

The capital requirements might have been stricter had it
not been for Greece. Escalating concern that the country
wouldn’t be able to service its debt, culminating in a May
bailout by the European Union and a $1 trillion rescue package
for other member states that may need it, darkened prospects for
economic recovery. That led some committee members to bend to
bank pressure, according to policy makers, central bankers and
others involved in the process.

By September, when the committee met to set the actual
capital ratios, the U.S. was pushing to require that banks have
common equity equal to 8 percent of their risk-weighted assets,
members said. It ended up at 7 percent, after Canada switched
sides at the meeting, tipping the balance toward the German
camp. Canada’s banks pressed their regulators to lower the ratio
because they said they would be punished unfairly as healthy
lenders that survived the crisis unscathed, the members said.

Even after being weakened, the new ratios and definitions
would require banks to hold about $800 billion more capital, the
committee said last week. Most lenders will be able to raise the
money by retaining profits before the rules go into effect.

Leverage Ratio

In addition to pushing for a higher capital ratio, Bair
also argued for a global leverage ratio that would cap banks’
borrowing -- something the U.S. has had on its books since the
1980s. In July, when the committee was debating how to define
capital, the U.S. agreed to some easing in exchange for Germany
and France accepting a leverage ratio, some members said.

Proponents of the leverage ratio, or equity as a percentage
of liabilities, say it’s a more straightforward way to prevent
lenders from becoming too indebted. Unlike capital ratios, which
are based on risk-weighting and can be manipulated, the leverage
ratio counts all assets regardless of their risk.

The more bankers borrow the more they can maximize profit
per share, a yardstick for determining compensation. The more
they borrow the higher the risk that a small decline in asset
prices can wipe out equity and make the bank insolvent.

No Correlation

The Basel committee adopted a 3 percent leverage rule in
July, meaning that for every $3 of capital, a bank can borrow no
more than $97. While the percentage is tentative and subject to
review before it goes into effect, it has since come under
attack by banks in Europe and Asia, which say it will restrict
their borrowing capacity and inhibit lending.

The EU may exclude the leverage ratio when it converts
Basel rules into law next year. Several member nations have
advocated dropping the rule, people close to the discussions
said last month. A majority of the 27 EU countries oppose
adopting the ratio, these people said.

“The argument is that this will restrain lending -- I hope
our colleagues in Europe don’t buy into this,” Bair said in an
interview earlier this month.

Recent academic research supports Bair. A July paper by
Jeremy Stein, a professor of economics at Harvard University,
and two colleagues looked at data going back to the 1920s and
found no correlation between higher capital ratios and costlier
lending by banks. An October paper by Anat Admati and three
other professors at Stanford University concluded that increased
equity levels don’t restrict lending.

‘Continuing Bickering’

“In the long run, higher capital has small impact on
lending,” said Stein in an interview. “But banks don’t like to
go out and get it. And regulators bought the banks’ arguments on
this. They could have been tougher.”

Bair, who first advocated the idea of an international
leverage ratio in a speech to committee members in Merida,
Mexico, in 2006, said she still expects global adoption.

Barbara Matthews, managing director of BCM International
Regulatory Analytics LLC, a Washington-based company that
advises on financial regulation, said the leverage ratio may not
make it in the end.

“Beyond tightening the definition of capital, nothing can
be really counted as having been achieved,” Matthews, a former
bank lobbyist, said of the Basel committee’s work this year.
“There’s continuing bickering over liquidity and leverage
regimes. They’re still studying too-big-to-fail issues, and it
might be too late to finalize them as events take them over.”

$6 Trillion

The Basel committee, established in 1974, proposed its
first liquidity standard, which would require banks to hold
enough cash or easily cashable assets to meet their liabilities
for up to a year. Running out of cash was behind the 2008
collapse of Bear Stearns Cos. and Lehman Brothers Holdings Inc.
in the U.S. and Northern Rock Plc in the U.K.

After banks showed they’d have to raise as much as $6
trillion in new long-term debt to be in compliance, the
committee delayed a final decision on the rule, setting up an
“observation period” of four to six years. It will likely be
revised, according to members.

“Liquidity is very important and still an outstanding
issue,” said Douglas Elliott, an economics fellow at the
Washington-based Brookings Institution and a former JPMorgan
Chase & Co. banker. “They’re trying to do it in the next couple
of years, but it could take many more years. Or it might never
get done if it proves too contentious.”

Resolution Mechanism

Lehman’s collapse also showed the need for a cross-border
mechanism to wind down failing banks that have a global reach.
More than 80 proceedings against the firm, involving hundreds of
subsidiaries worldwide, have complicated recovery by creditors
and destroyed much of the value of its assets.

The Financial Stability Board, which includes most Basel
committee members as well as finance ministers from the Group of
20 nations, struggled to come up with such a resolution
mechanism this year. The FSB postponed a decision until next
year after divisions among nations proved too wide to bridge,
members said. The group has been unable to agree on how to
distribute losses among countries when a global bank fails and
how different legal jurisdictions can recognize a single
authority to pay creditors, the members said.

Too Big to Fail

The FSB is also responsible for determining which banks are
systemically important and whether to impose additional capital
requirements on them. The group may propose setting up national
resolution authorities, rather than an international body,
members said. Instead of a global accord on a surcharge for the
largest banks, it may suggest a menu of options.

“Nobody’s been able to fix too-big-to-fail around the
world because nobody knows how to do it,” said Hal Scott, a
Harvard Law School professor who also is director of the
Committee on Capital Markets Regulation, a nonpartisan group of
academics and business executives. “Even figuring out how to
resolve giant banks nationally is tough. How can you do it
internationally? That was the biggest lesson of the crisis,
systemic risk, but that’s still unresolved.”

Many issues may never be resolved, said Frederick Cannon,
co-director of research at Keefe, Bruyette & Woods Inc. in New
York, a firm that specializes in financial companies. G-20
leaders meeting in Seoul last month sounded as if they were
claiming victory for regulatory reforms, even if they weren’t
completed, Cannon said.

“Before Seoul, I was expecting more reforms to be
concluded next year,” he said. “But now, more and more, I
believe this is what we’re getting, nothing more. They got a 7
percent common equity requirement -- the rest is all uncertain
to ever happen.”

‘Glass Half Full’

Charles Goodhart, a former Bank of England policy maker and
professor at the London School of Economics, said he is more
optimistic that differences will be resolved in coming years.

“There is still lots to be done, but we haven’t lost the
momentum,” Goodhart said. “We’re 50 percent of the way there.
We need to see it as the glass half full.”

Bair, who is stepping down from her FDIC position when her
term expires in June, said she hopes the reforms will continue
after she leaves the Basel committee. One remaining challenge,
she said, is the reliance on banks’ internal models for
measuring risk.

While smaller banks use standard risk-weightings prescribed
by Basel, the largest banks use their own formulas to determine
how much risk to assign their assets in calculating capital
ratios. That leads to wide variations in how risk-weighted
assets are tallied, Bair said.

“We have to get beyond too much reliance on banks’
internal models, their own views on risk,” she said.